In the penultimate week of our course, we returned to the subject of regulation of financial innovation.This was the sequel to our work in Week 5, where we discussed regulation as a driver of financial innovation—left unsaid that week was the question, “If we don’t think regulation works so well, what should we do about it?”So, after reviewing the very wide range of financial innovations, we turn to that question.In addition, giving some attention to regulation invites us to lift our gaze to the very highest level of financial innovation and consider how we might sustain systemic stability through regulation.

If it’s broke, fix it.

Our visiting speaker, Jo Ann Barefoot, helped to frame for us some fundamental challenges with financial regulation.She noted that the finance sector of the economy is the most pervasively regulated sector after health care.And our readings and discussions this semester remind us that frauds, panics, and other outcomes against the public interest occur regularly.Enforcement gets some of the miscreants.And pre-emptive remedies work imperfectly.Pricking an asset bubble is very hard to do well.Disclosure of information is boring, uninteresting, and doesn’t protect people very well.The financial system seems structured to discourage access: some 70 million Americans are unbanked or underbanked.The regulatory regime is fragmented and fraught with internal turf battles.The regulatory process is slow to change: it takes two years to make a new regulation.And new regulations tend to look backward at problems just occurred, rather than forward at threats on the horizon.Regulators have some discretion about enforcement, can get captured by the industry they regulate, and/or can be sleepy or overoptimistic in their enforcement efforts.Some regulators try to pick winners and losers in an industry, thus pre-empting and distorting the discipline of markets.Finally, regulators resist change and/or attend to their own self-interest, to protect their prerogatives and obtain a budget appropriation for the next year.

Some of these criticisms echo my blog post in Week 5.There, I challenged the reader to consider why we regulate the financial sector.Releasing firms and individuals from regulatory constraints has popular appeal, as candidates in the recent election suggested.But there is less clarity about what that business environment would actually look like.In the pure state of nature without any laws and regulations, life would be (as Thomas Hobbes put it) “solitary, poor, nasty, brutish, and short.”Almost no one advocates an absolutely free market, so the question comes down to how much regulation to impose.The answer to that question depends, as I wrote in my earlier post, on what kinds of risk and how much risk one is willing to accept in daily life.

The aims of financial regulation are to promote values that prevail in society: fairness, equality of opportunity, honesty, transparency, and stability (i.e. risk management).Of these, stability warrants more consideration.Throughout the course, we focused on discrete segments of the financial sector.But as I argued at various points along the way, the parts of the financial system are so tightly interconnected that the impact of a financial innovation in one area is bound to be felt elsewhere.Trouble can travel.I’ll have more to say about stability in my post for Week 14.

In short, it is hard to find anyone who is truly satisfied with the current system of financial regulation.But totally eliminating financial regulation seems unlikely to gain a majority in Congress.We are left with tinkering with the existing system.It’s broke, so let’s fix it.

How to fix it?Some proposals.

Our readings for the week and our visiting speaker highlighted some of the prominent proposals.These aren’t an exhaustive list of the bright ideas floating around.But our discussion helped to exercise skills of critical assessment that might be shone on other proposals that come along.

1.Privatize deposit insurance.We could demand that banks participate in a private insurance company that would take the FDIC out of business.Bert Ely argued that this would give banks even more “skin in the game,” reduce moral hazard, and take the taxpayers off the hook as funder of last resort.Gary Gorton countered that while the proposal would improve the incentives for responsible lending among individual institutions, it removes a valuable crisis-fighter in the event of another financial system meltdown.

2.Establish an FDA-like agency to review and certify new financial products for their “social utility.”Posner and Weyl argued that financial products can be dangerous to the wealth of individuals.Just like the FDA certifies the efficacy of new drugs, a new watchdog for financial products could certify financial innovations.The goal would be to assure that such innovations are used for insurance, not gambling.On the other hand, this proposal would discourage financial innovation, lengthen the time-to-market, drive entrepreneurs out of the country, and/or drive up the cost of new financial products.The distinction between insurance and gambling is fraught.

3.Boost the capital requirements for banks.Anat Admati and Martin Hellwig argued that the Basel III requirement for about 9% % capital/assets is inadequate and that the effort to calibrate equity requirements to the risk of a bank’s assets creates false confidence.They suggest that the target capital requirement should be raised to ~20-30% of assets.This would put more equity capital at risk, deepening the ability to absorb loan losses, countering moral hazard, and perhaps turning banks into sleepy utilities rather than go-go risk-takers.As one might imagine, the banking industry vehemently opposes this, declaring it a misuse of capital that will destroy the economic incentives, constrain the availability of capital and depress economic growth.But more recently, I have heard some bankers argue that they would accept the higher capital requirements if the government rescinded most (or all) other regulations on the industry.

4.More macroprudential regulation and structural redesign.As opposed to “microprudential regulations,” which aim to protect the individual firm or person, “macroprudential regulation” seeks to reduce instability in the financial system.Since the Panic of 2008, macroprudential regulation has been a hot topic.Such regulations measure monetary aggregates, leverage to GDP, capitalization and liquidity of banks, as well as the correlation in performance among banks, i.e., a recognition that trouble can travel.Kathryn Judge argues for greater regulatory intervention to redesign the financial system.She notes that financial innovation and the consequent growth in complexity of the financial system heightens systemic risk.With more complexity there is a greater loss of information.And because of the rapid rate of innovation, more disclosure of information won’t suffice.Regulators need to intervene to shorten the intermediation links between the issuer of claims and the investor.As business process engineers tell us, simplification is generally a good thing.But at what cost?As with the FDA-like proposal (#3 above) experience suggests that greater regulatory intervention might clog the system rather than declutter it.And why is the judgment of a regulator better than the market itself?The regulator may be able to instill some order in the common interest, but the market participants are closer to the technical challenges and doubtlessly have a great deal of “skin in the game.”

5.Get tech savvy. Cornelia Levy-Bencheton shifts our gaze from the challenges posed by the recent financial crisis and toward the current wave of financial innovation, “fintech.”She acknowledges the enormous compliance burden on banks imposed by Dodd-Frank—by her analysis, it takes 24 million person-hours of work per year for the U.S. banking system to comply with that regulation alone.And she also points to the disruptive force of fintech.“We are in hell,” she wrote, because of the “four V’s” of big data: volume, variety, velocity, and veracity.Her solution: banks must develop a data-driven culture; they must “leverage emerging digital business models, modernizing traditional channels and modeling what is happening in other industries…And new data that needs to be integrated into existing information sets to make banking organizations more agile and effective if they are to stand a prayer of staying relevant.”Our visiting speaker, Jo Ann Barefoot, outlined some big issues facing regulators as they strive to stay relevant as well.She cited data management, privacy, fairness, discrimination, failures of disclosure, systemic health, speed of innovation, and the complex regulatory framework.“Reg tech” is bringing technology to address regulatory challenges of disclosure, compliance, risk identification, and risk management.15-20 countries have “regulatory sandboxes” in which financial innovators can try out their ideas on live customers with less regulatory intervention during the research process.

So what?

The subtext of our work this week is a radical idea, that we can expand the definition of “financial innovation” beyond the private sector to include financial policy innovations in the public sector.If we define the perimeter of the financial system to include the regulatory actors, we gain more clarity about opportunities and problems associated with financial innovation.And defining the perimeter more broadly invites us to consider how transferrable is the business perspective into public policy, and vice versa.We want rules and watchdogs motivated by the public interest, rather than the welfare of some subset of society.But as our review of the pros and cons of particular proposals suggests, critical scrutiny and wisdom know no country.